Service Stream Limited (SSM) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Service Stream Market Update. [Operator Instructions] I would now like to hand the conference over to Mr. Leigh MacKender, Managing Director. Please go ahead.

Thank you. Good morning, ladies and gentlemen, and thank you for joining us for today's briefing following the company's market update, which we released yesterday afternoon. As per the introduction, my name is Leigh MacKender, Managing Director of Service Stream. And I'm joined today by our Chief Financial Officer, Linda Kow; and I have our Head of Investor Relations, Chloe George with me also. As per the introduction, we're recording the session today via webcast. It's open to all Service Stream shareholders. We have a number of institutional investors and analysts on the bridge, whom are welcome to ask questions at the conclusion of the presentation. And I'll walk through yesterday's announcement. And at the conclusion of the call, I'll hand back to the moderator to open up the briefing for questions. Okay. Yesterday afternoon, the business released a market update with regards to the onerous Queensland water project and an update with regards to the final cost to complete. The second aspect of the market update was a trading update, an insight to the group's unaudited financial results for the half year ending 31 December to provide context to the broader group's performance. I'll start first with the Queensland water project. Service Stream was contracted to design and construct a 27-kilometer pipeline and a water transfer or pumping station in Southern Queensland. It was a fixed price contract and was entered into by the legacy Service Stream business Comdain Infrastructure division over 2 years ago. As we reported, the group's FY '22 full year results, the projects unfortunately suffered delays due to resourcing constraints, both across our in-sourced field operations and those of our specialist third-party partners and contractors that the business was relying on for services such as detailed design. The impacts were further exacerbated by multiple and prolonged wet weather delays across Queensland during the second half of last year and by latent conditions. As a result, the group wrote back a small profit, which have been recognized to that point; the project moved to a loss position; and we recognized a $5 million onerous contract provision as of 30th of June in terms of what -- at that point, we had the expected cost to complete the project. So where do we find ourselves today? With the business having recently completed the major design activities across all work packages and in the process of working through the remaining construction works, the business completed simultaneously internal and external reviews of the cost to finalize the project. It's very unfortunate that during those reviews, the business has determined the project will require an additional $20 million, which does include prudent contingency to cover final construction costs and support the project's completion by the end of calendar year '23. Magnitude of that increase is certainly unlost on me or the management team. To break that down a little further, a few million dollars in additional costs, which forms part of the $20 million, did become evident towards the end of the last half and was largely due to the delayed design process and the extension of program duration. This, however, wasn't significant in the context of the group, given the performance of our broader business and specifically our telecommunication operations we're performing ahead of expectations. But given the progression of the projects, remaining elements that had reached design milestones, and the scope was therefore locked down, the business offering to undertake the simultaneous internal and external reviews of the cost to complete the project line by line across each aspect of the scope to be delivered. The additional costs that were discovered are associated with those design delays, some scope development throughout the design process, increased labor and material costs aligned to current market forces and overheads to cover the project's completion given the slippage and schedule. And this revision again does include a prudent project contingency. Again, I'm obviously very disappointed that we've had to increase the provision for this single project and the increase of this magnitude. Certainly committed to quarterizing what is a single project, ensuring that the work is completed in calendar year '23, so the business can move ahead and leave this troubled project behind. These additional costs will be recognized as part of the group's half 1 FY '23 results, which we released shortly. Importantly, we've not increased the contract provisions taken at June 30 with regards to claims, disputes, variations and work to resolve those is continuing and will be escalated over the coming months. I understand engaging for our shareholders and the broader market over the last half that this single project has understandably been an area of focus and a lot of questions. The revisions that we've outlined today will allow the project to be successfully completed, and I hope that it provides shareholders with confidence that the broader performance across the business can shine through, including that of our utility division's other operations and that, that performance will not be further eroded into the future. Service Stream across the group had in excess of 170 contracts and a strong pipeline of growth opportunities associated with the operations and maintenance of critical infrastructure. As many know, our business has not historically undertaken these types of large-scale fixed-price design and construction agreements. And over the last half, we have pivoted the utility division to focus on opportunities aligned to operations and maintenance works, particularly given the expanded capabilities that we gained through the Lendlease Services acquisition, and that is now fully integrated across the Service Stream business. Moving to the trading update with respect to the group's half year results, which are subject to our half year order that is currently underway, and the results are due to be released on 22nd of February. The broader business has generally performed well outside of our utility operations, and that diversified portfolio that we now have is providing benefit. Telecommunications division has been a particular standout, it's benefited from strong work volumes across both wireless and fixed-line operations. And the division was successfully -- has been able to successfully accelerate some of the works that were expected to be completed in early half 2 into the latter stages of half 1. Our transport operations is performing in line with expectations. The group's first half EBITDA from operations, [ we gained ] $54 million. That excludes the $20 million provision that we've taken to this project. With regards to full year, the group has not released guidance. However -- we are, however, conscious that market consensus for the business, which is $114 million in EBITDA from operations. The project impact of $20 million we've just outlined would not have been envisaged in these numbers, and as I said, will be incurred in half 1. If we look into half 2, the group still expects a slight increase or bias, again, aligned to our historical business performance. So hopefully, these numbers allow our shareholders to triangulate where we believe the group will finish for the full year. The group's balance sheet remains in a strong position, closing net debt of $91.2 million. This compares to a June position of $81.3 million, which did reflect some working capital timing benefits to deliver an OCFBIT of 108%, which management discussed throughout last year's results, with some of that expected to reverse in this half as we outlined. The increased provision also reflects strong telco volumes, particularly over Q2 and our wireless operations ramping up, and that results in a buildup of working capital for these contracts. Half 1 cash flow includes the absorption of costs associated with the pipeline circa $16 million, but note that project was only approximately 50% complete at June. And finally, the Board is expected to declare an interim dividend of $0.05 per share for the half year, and that's obviously subject to completion of the half year order, which as I said, is underway. Again, the impact of the utility revision is certainly not lost on Board, myself and Service Stream management. The business is committed to seeing this project through to completion and then allowing our business to focus on more broader business operations. I'll now hand back to the moderator. I'm conscious we may have a number of questions from those joining us and happy to take those.

[Operator Instructions] Your first question comes from Piers Flanagan from Barrenjoey.

Leigh and Linda, just a couple for me, if I can. Just firstly, on the provision and the $20 million increase. Can you just give us a bit more color on the overruns, I guess, sort of what sits within design and then expectations for construction? Just trying to get a sense of if we look forward, I mean, do you have the labor that you need now and hence, all the materials on hand to complete this project?

Appreciate the question, Piers. So the additional cost, as I said, a portion of that was associated with design delays. So the expansion of the project or the extension of the project in terms of time duration. So those design delays cost us to go through that process but also then pushed the schedule out. The other aspects are around that scope development through the design process and refining what needs to be delivered, and then increases in labor and material costs as and -- given those sort of market forces, ensuring we've got the right overheads and cost structure, support structure to deliver the project. So very conscious. Second part of your question, which is around resourcing. The team has gone through detailed line-by-line reviews of every aspect of the project that needs to be delivered to see it through to completion, are confident that they have subcontractors and resources on board, and the updates will require them to finish the project within the confines of this $20 million.

And it's right to think about it in -- these design costs have now completed though? So that's already...

Knowing the design milestones -- yes, design milestones have been achieved. It allows us now to move forward to the construction of the final phase, which is the water transfer station, and that is the remaining elements that need to be completed.

Sure. And just on the rest of the contracts that you have within the business, and I know you touched on it briefly, but any other fixed price contracts? And are you able to provide any commentary on just the size of them?

Yes. As we discussed at the half year, we had -- obviously, this is part of a trial of looking at expanding capabilities to large-scale design and construction, and we've since importantly pivoted away from these sorts of works that are circa $30 million, $40 million and over a long duration of time at a fixed price. We had discussed at 30th June that we had 2 other projects. We have one which is in the final stages of completion in Queensland, which is associated with a SCADA upgrade, that will be finished in February. We have brought forward the completion of those works. We have looked to get that completed as soon as possible and bringing that forward in February, has been a priority. The other project that we have is a treatment facility in Gisborne, very different scope of works, and that is at 5% complete. Again, very, very different to the size and scale of this project. That project is about $30 million and is more aligned to what the business had historically taken. No doubt, the learnings from this understandably have filtered through to our utility team that are overseeing that project, and we're insuring and have insured over the last few months that we really get into a granular level of detail on that other water project that is at that very start to make sure that, that doesn't fall through the same path.

And then just a final one just on the balance of the business and the strong telco performance over the first half. Can we just talk about some of the drivers behind those volumes? And are you still seeing that, I guess, over the second half of the 6 weeks that we've had?

Yes, that's a great question. We certainly have seen strong performance across telecommunications. As I said, it's been both in our wireless operations and fixed line. Whilst we're seeing an increase in wireless as a portion of our revenue, we're seeing more spend increasing from all our wireless providers as we reported as part of the acquisition. We're now providing services for all wireless telecommunication providers for this country. So that's positive. It does build up some working capital as I outlined. But certainly, there is a strong run rate ahead of us there. Fixed-line operations, faults maintenance, network upgrades, that's continuing to also perform well. We did bring forward and were able to accelerate a small portion of those programs into the end of the last half, but we still have a lot of work ahead of us, significant opportunities for telco, and I think that will have another really positive performance for -- with regards to the full year.

Your next question comes from Marni Lysaght from Macquarie.

First one is just about, I guess, the rebasing of the business. So you did flag to us over the last calendar year that you're pivoting away from this project and going into more O&M and utilities. But the extent of, I guess, some of the impact on that of you -- of your kind of, I guess, level of -- like of operating performance moving forward, has that changed now following this review?

No, I think -- thanks, Marni. No, absolutely not. So we started that pivoting process when we first became aware of this project running out, and we talked about it at the last half. And those expanded capabilities we acquired through the Lendlease acquisition are more associated with operations and maintenance, which is akin to our core competencies. Lendlease also brings in capabilities associated with power. So operations, maintenance and minor capital works with -- of power and electricity networks, which is a growing area of focus and will be for us, and I think provides a lot of opportunities. Gas and industrial services, maintenance and shutdown is another area that we are seeing strong volumes and again, have those capabilities from Lendlease that have really allowed us to pivot away from what was that trial in the traditional business of looking to expand and grow our water capabilities. So we'll certainly be focusing on those latter aspects, which are complemented through Lendlease's acquisition.

Sure. And another one for me just to remind us of like the margin profile of D&C with the utilities versus the operation and maintenance.

Yes. Look, we don't generally split that out. And the utilities is generally sort of a 5% to 7% business. I think D&C, we've talked about previously, has traditionally been lower than that. The difference being, obviously, you've got a higher risk there. You've got design and construction elements. It is somewhat fixed price, generally. Whereas O&M over a journey, often, you have a relationship or a contracting cycle that spans many years. And you're, therefore, able to drive initiatives and improvements to improve your margin over time. So traditionally, we do see an improved margin from our O&M operations as opposed to design and construction, generally speaking.

Excellent. And just a final one for me. Is this around net debt as at the balance date of that circa $90 million? Just to clarify, I know you did make some comments around cash flows on the call, but that -- I understand, obviously, you can't repeat what -- the strong cash flow conversion you had in the first half of '22. But is that -- does that $90 million capture all the kind of -- the unwind of that?

Look, I understand the question. I think it does. We'll certainly have -- obviously, there's $20 million of outflow over the course of the next calendar year. So that will flow into this year and part of next. Outside of that, the business continues to perform well in terms of cash flow generation. And Linda and I did call out, again, per my earlier comments, at the full year that we did expect to see a lower conversion rate this half anyway. We've stated that we always sort of strive to get an 80% conversion rate, but did expect in this first half, it would be lower. We called that out, very good visibility in terms of cash flow performance across the business. You could see that, that was going to be an unwind plus the buildup of working capital in our wireless telecommunication operations and broader business. We could see that those aspects were going to take effect.

And you're still comfortable to get the gearing down in due course down to that 1x EBITDA number despite these...

Yes. Certainly, when we acquired -- when we made the acquisition, we stated -- obviously, we're coming out of the blocks at a higher leverage ratio. And we did state then that we thought given sort of 2 years' time from completion, we would aim to try and get around that sort of 1x, and that was what we did [ do. So that ] will need to be reviewed here in context of this, we're going to have the $20 million. But I think we're still looking to absolutely get to around that sort of 1x number.

Your next question comes from Ian Munro from Ord Minnett.

Just a couple of questions for me, please. Just firstly, can you give us a sense of the percent project completion and perhaps the complexity of the remaining elements of the project relative to what you've already completed?

It's a great question, Ian, so I appreciate it. We're probably now about, I'd say, circa 60% to 70% through the project. I can get an absolute number and -- concerning that, and we will provide an update at the half year. In terms of the complexity, we've really finished the most complex aspects, from my perspective, being the design process. Design is not one design, it's multiple designs across every aspect, and we rely on third parties to help us finalize that design so we incur their costs, and we have to manage them around the scope. What we have now reached is a period where it's effectively a construction-only project. So design has been finished, we now need to go forward and construct that. And that's the way in which we're sort of viewing this now is it's a construction project, the team has rebased the price, looked at it line by line, each aspect of the remaining works, which is largely around the transfer station and some minor pipe work. And as I said, we're very, very conscious of the need to ensure that we've got prudent contingency. It is one thing to have a revision that we do June, it's the second thing to have a second time like we have to date. So we wanted to ensure that we had that contingency to cover that aspect of work for the remaining months that will see us through to late calendar year '23.

And how do we know that $20 million is enough?

Yes. No, it's certainly a good question. We've gone through -- I think one aspect is the design being finalized. So you then know exactly what needs to be constructed and there is no ambiguity there. I think the second aspect is that we've gone through -- or the team have gone through a detailed line-by-line analysis of all the aspects of scope, work and cost to deliver it. And that review has been done by 2 internal teams, 2 separate internals and an external to review that. So we certainly have tried to do the very best we can in analyzing and scrutinizing all those costs to make sure that we've got an understanding of what that cost will be given market conditions, et cetera, to finish the project.

And just finally, the release makes reference to focusing on resolving commercial matters. Perhaps can you give us a sense of Service Stream ever sort of gotten into a commercial dispute with a key customer like this before? And how should we be thinking about liquidated damages in either direction? And perhaps your strategy in that segment.

The reference there certainly is to variations, disputes, claims. And we have some variations of decline that we talked through at the half year that we need to have -- or the full year, sorry, that we need to have reconciled. We've taken a position on those cents in the dollar that we believe is absolutely appropriate, and we have independent experts to support our position. We've not, at this stage, looked to progress any matters downstream to parties that may have had a hand in or impacted our performance negatively. We have had disputes with clients over the journey. This is part of a contracting business, you do have them from time to time, and our business always tries to work proactively with clients to try and deal to the matters. And we certainly hope that in this instance that our client will assist us in finalizing any of those outstanding commercial matters. Liquidated damages is a risk for us. There is LDs that is capped at a percentage of the contract, which is 10%. So it's about $5 million of the original sum, and they've not been levied on us. It's, again, part of what we're negotiating with our variations at the moment. Incorporated into this number, though, Ian, is the view of total magnitude to finish the project based on what we have today.